UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

Form 10-QSB

(Mark One)

[X]          QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2006

[  ]           TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT

For the transition period from _______________ to _______________.

Commission file number 333-23617

                Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes     X      No        

                Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes              No     X  

Applicable only to issuers involved in bankruptcy proceedings during the preceding five years

                Check whether the registrant filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Exchange Act after the distribution of securities under a plan confirmed by a court.
Yes           No          

Applicable only to corporate issuers

                State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date.  As of July 31, 2006, there were 255,538,703 shares issued, and 194,216,215 shares outstanding, of our Series A common stock.  As of July 31, 2006, there were 600,000 shares of Series B common stock issued and outstanding.

MATERIAL TECHNOLOGIES, INC.


TABLE OF CONTENTS

PART I – FINANCIAL INFORMATION........................................................................... 2

ITEM 1     Financial Statements................................................................................................ 2

ITEM 2     Management’s Discussion and Analysis or Plan of Operation................................. 35

ITEM 3     Controls and Procedures....................................................................................... 44

PART II – OTHER INFORMATION............................................................................... 46

ITEM 1     Legal Proceedings................................................................................................. 46

ITEM 2     Unregistered Sales of Equity Securities and Use of Proceeds................................. 46

ITEM 3     Defaults Upon Senior Securities............................................................................ 47

ITEM 4     Submission of Matters to a Vote of Security Holders............................................. 47

ITEM 5     Other Information................................................................................................. 47

ITEM 6     Exhibits................................................................................................................ 47

1

PART I – FINANCIAL INFORMATION

          This Quarterly Report includes forward-looking statements within the meaning of the Securities Exchange Act of 1934 (the “Exchange Act”).  These statements are based on management’s beliefs and assumptions, and on information currently available to management.  Forward-looking statements include the information concerning our possible or assumed future results of operations set forth under the heading “Management’s Discussion and Analysis of Financial Condition or Plan of Operation.”  Forward-looking statements also include statements in which words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “estimate,” “consider” or similar expressions are used.

          Forward-looking statements are not guarantees of future performance.  They involve risks, uncertainties and assumptions.  Our future results and shareholder values may differ materially from those expressed in these forward-looking statements.  Readers are cautioned not to put undue reliance on any forward-looking statements.

ITEM 1          Financial Statements

2

See accompanying notes to the consolidated financial statements

3

See accompanying notes to the consolidated financial statements

4

See accompanying notes to the consolidated financial statements

5

See accompanying notes to consolidated financial statements

6

See accompanying notes to consolidated financial statements

7

See accompanying notes to consolidated financial statements

8

9

NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The accompanying consolidated financial statements include the accounts and transactions of Material Technologies, Inc. and its subsidiaries.  Intercompany transactions and balances have been eliminated in consolidation.  The minority owners’ interests in a subsidiary have been reflected as minority interest in the accompanying consolidated balance sheet.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Significant estimates include the fair value of marketable and non-marketable securities, the recoverability of long-lived assets and the amount of the deferred tax valuation allowance.  Accordingly, actual results could differ from those estimates.

Cash Equivalents

For purposes of the statements of cash flows, the Company considers cash equivalents to include highly liquid investments with original maturities of three months or less.

Investments

Marketable securities purchased with the intent of selling them in the near term are classified as trading securities.  Trading securities are initially recorded at cost and are adjusted to their fair value, with the change in fair value during the period included in earnings as unrealized gains or losses.  Realized gains or losses on dispositions are based upon the net proceeds and the adjusted book value of the securities sold, using the specific identification method, and are recorded as realized gains or losses in the consolidated statements of operations.  Marketable securities that are not classified as trading securities are classified as available-for-sale securities.  Available-for-sale securities are initially recorded at cost.  Available-for-sale securities with quoted market prices are adjusted to their fair value.  Any change in fair value during the period is excluded from earnings and recorded, net of tax, as a component of accumulated other comprehensive income (loss).  Any decline in value of available-for-sale securities below cost that is considered to be “other than temporary” is recorded as a reduction of the cost basis of the security and is included in the statement of operations as an impairment loss.

Non-marketable securities consist of equity securities for which there are no quoted market prices.  Such investments are initially recorded at their cost.  In the case of non-marketable securities acquired with the Company’s common stock, the Company values the securities at a significant discount to the stated per share cost based upon the Company’s historical experience with similar transactions as to the amount ultimately realized from the sale of the shares.  For the Birchington shares (see Note 3), the Company has applied an 80% discount to the stated per share cost.  Such investments will be reduced if the Company receives indications that a permanent decline in value has occurred.  At such time as quoted market prices become available, the net cost basis of these securities will be reclassified to the appropriate category of marketable securities.  Until that time, the securities will be recorded at their net cost basis, subject to an impairment analysis (see Note 3).

Convertible Debentures

If the conversion feature of conventional convertible debt provides for a rate of conversion that is below market value, this feature is characterized as a beneficial conversion feature (“BCF”).  A BCF is recorded by the Company as a debt discount pursuant to EITF Issue No. 98-5 (“EITF 98-05”), “Accounting for Convertible Securities with Beneficial Conversion Features or Contingency Adjustable Conversion Ratio,” and EITF Issue No. 00-27, “Application of EITF Issue No. 98-5 to Certain Convertible Instruments.”  In those circumstances, the convertible debt will be recorded net of the discount related to the BCF.  The Company amortizes the discount to interest expense over the life of the debt using the effective interest method.

Derivative Financial Instruments

In the case of non-conventional convertible debt, the Company bifurcates its embedded derivative instruments and records them under the provisions of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended, and EITF Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”  The Company’s derivative financial instruments consist of embedded derivatives related to the non-conventional notes (“Notes”) entered into with Golden Gate Investors (“GGI”) on December 16, 2005 (see Note 6).  These embedded derivatives include the conversion feature, liquidated damages related to registration rights and default provisions.  The accounting treatment of derivative financial instruments requires that the Company record the derivatives and related warrants at their fair values as of the inception date of the agreement ($5,917,188 recorded as interest expense and $40,000 recorded as debt discount) and at fair value as of each subsequent balance sheet date.  Any change in fair value will be recorded as non-operating, non-cash income or expense at each reporting date.  If the fair value of the derivatives is higher at the subsequent balance sheet date, the Company will record a non-operating, non-cash charge.  If the fair value of the derivatives is lower at the subsequent balance sheet date, the Company will record non-operating, non-cash income.  During the quarter ended June 30, 2006, the Company modified the terms of one of its convertible debt agreements and recorded a decrease to the fair value of the derivatives and related warrants of $2,257,071.  As of June 30, 2006, derivatives were valued primarily using the Black-Scholes Option Pricing Model with the following assumptions: dividend yield of 0%, annual volatility of 200%, and risk free interest rate of 5.25%. 

Fair Value of Financial Instruments

The Company’s financial instruments consist of cash and cash equivalents, investments, accounts receivable, accounts payable, accrued expenses, notes payable, convertible debentures and derivative and warrant liabilities.  Pursuant to SFAS No. 107, “Disclosures About Fair Value of Financial Instruments,” the Company is required to estimate the fair value of all financial instruments at the balance sheet date.  The Company cannot determine the estimated fair value of the convertible debentures as instruments similar to the convertible debentures could not be found.  Other than these items, the Company considers the carrying values of its financial instruments in the financial statements to approximate their fair values.

Revenue Recognition

The Company recognizes revenue in accordance with Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements,” as revised by SAB No. 104.  As such, the Company recognizes revenue when persuasive evidence of an arrangement exists, title transfer has occurred, the price is fixed or readily determinable and collectibility is probable.  Sales are recorded net of sales discounts.

Substantially all of the Company’s revenue is derived from the Company’s contracts relating to the further development of the Electrochemical Fatigue Sensor (“EFS”).  Revenue on the contracts is recognized at the time services are rendered.  The Company bills monthly for services pursuant to these contracts at which time revenue is recognized for the period that the respective invoice relates.  In October 2003, the Company entered into a contract to provide research services to a third party in connection with the application of the Company’s EFS to detect stress on military vehicles.  The contract has an approved budget of $215,281.  The Company was fully paid for services rendered through June 30, 2006 and had no balance owed under the contract.

In the past, the Company has received research and development funding from various agencies of the U.S. government.  U.S. government contracts are subject to government audits.  Such audits could lead to inquiries from the government regarding the allowability of costs under U.S. government regulations and potential adjustments of contract revenues.  To date, the Company has not been involved in any such audits.

Research and Development

The Company expenses research and development costs as incurred.

Net Loss per Share

The Company adopted the provisions of SFAS No. 128, “Earnings Per Share” (“EPS”).  SFAS No. 128

Issuance of Stock for Non-Cash Consideration

All issuances of the Company's stock for non-cash consideration have been assigned a per share amount equaling either the market value of the shares issued or the value of consideration received, whichever is more readily determinable. The majority of the non-cash consideration received pertains to services rendered by consultants and others and has been valued at the market value of the shares on the dates issued.  In certain instances, the Company has discounted the values assigned to the issued shares for illiquidity and/or restrictions on resale (see Note 8).

The Company's accounting policy for equity instruments issued to consultants and vendors in exchange for goods and services follows the provisions of EITF 96-18, “Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” and EITF 00-18, “Accounting Recognition for Certain Transactions Involving Equity Instruments Granted to Other Than Employees.”  The measurement date for the fair value of the equity instruments issued is determined at the earlier of (i) the date at which a commitment for performance by the consultant or vendor is reached or (ii) the date at which the consultant or vendor's performance is complete.  In the case of equity instruments issued to consultants, the fair value of the equity instrument is recognized over the term of the consulting agreement.  In accordance with EITF 00-18, an asset acquired in exchange for the issuance of fully vested, nonforfeitable equity instruments should not be presented or classified as an offset to equity on the grantor's balance sheet once the equity instrument is granted for accounting purposes.  Accordingly, the Company records the fair value of the fully vested non-forfeitable common stock issued for future consulting services as prepaid services in its consolidated balance sheet.

Stock-Based Compensation

Prior to January 1, 2006, the Company accounted for its stock-based compensation plan under the recognition and measurement provisions of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, as permitted by Statement of Financial Accounting Standards (“SFAS”) No. 123, “ Accounting for Stock-Based Compensation.”

As of June 30, 2006, the Company’s investment in an open-end mutual fund approximated its cost of $131,855.  The Company considers its investment in this account as being held for trading.  During the three months ended March 31, 2006, the Company sold $174,988 of this investment and recognized a net loss on the transactions totaling $24, which was charged to operations.  There were no sales during the three month period ended June 30, 2006.

Investments as of June 30, 2006 are as follows:

Under the terms of the agreement, the Company issued to the University 13 shares of its common stock, and a 5% royalty on sales of the product.  The Company valued the license agreement at $6,250.  The license terminates upon the expiration of the underlying patents, unless sooner terminated as provided in the agreement.  The Company is amortizing the license over 17 years.

In addition to the license agreement, the Company also agreed to sponsor the development of EFS.  Under the sponsorship agreement, the Company agreed to reimburse the University development costs totaling approximately $200,000, to be paid in 18 monthly installments of $11,112.  Under the agreement, the Company reimbursed the University $10,000 in 1996 for the cost it incurred in the procurement and maintenance of its patents on EFS.

The Company and the University agreed to modify the terms of the license and sponsorship agreements and related obligation.  The modification of the license agreement increased the University's royalty to 7% of the sale of related products and provided for the issuance of additional shares of the Company's common stock to equal 5% of the outstanding stock of the Company as of the effective date of the modification, subject to anti-dilution adjustments.  The modification of the sponsorship agreement included paying the University 30% of any amounts raised by the Company in excess of $150,000 (excluding amounts received on government grants or contracts) up to the amount owing to the University.

The parties agreed that the balance owed on the sponsorship agreement was $200,000 and commencing September 30, 1997, the balance accrued compound interest at a rate of 1.5% per month (19.6% effective annual rate) until maturity on December 16, 2001, when the loan balance and accrued interest became fully due and payable. 

In August 2005, the parties entered into an agreement (the “Workout Agreement”) that again modified the terms of the Company’s obligation under the sponsorship agreement.  Pursuant to the Workout Agreement, retroactive to January 1, 2005, interest will be charged only on the December 31, 2004 balance of $760,831 (“Remaining Obligation”) at a monthly rate of 0.5% simple interest.  The Company is obligated to pay $25,000 annually due on the anniversary date of the Workout Agreement.  Further, the Company is also obligated to pay within ten days following the filing of the Company’s Forms 10-QSB or 10-KSB an amount equal to 10% of the Company’s net income before extraordinary items and income taxes as reflected in the quarterly and annual filings.  Under the revised terms of the Workout Agreement, Mr. Bernstein’s, the Company’s president, annual cash salary is capped at $250,000.  The Company agreed to pay the University an amount equal to any cash salary paid to Mr. Bernstein in excess of the $250,000, which will be credited against the Remaining Obligation.  In accordance with the terms of the

During the quarter ended March 31, 2006, the Company made a payment of $25,000 to the University to reduce the outstanding principal on the note.  Interest expense charged to operations for the six months and three months ended June 30, 2006 amounted to $21,338 and $10,633, respectively.  Interest expense charged to operations for the six months and three months ended June 30, 2005 (restated) amounted to $22,824 and $11,412, respectively.  The balance of the obligation (including accrued interest) at June 30, 2006 was $777,523 and is reflected in research and development sponsorship payable in the accompanying consolidated balance sheet.  The current portion represents the minimum annual payment under the Workout Agreement, while the remaining balance is reflected as non-current as the Company does not expect to be required to make additional payments during the next twelve months.

No amounts are due to the University as of June 30, 2006.

NOTE 5 – NOTES PAYABLE

On May 27, 1994, the Company borrowed $25,000 from a shareholder.  The loan is evidenced by a promissory note bearing interest at 6.5 percent.  The note is secured by the Company’s patents and matured on May 31, 2002.  The loan has not been paid and is now in default.  As additional consideration for the loan, the Company granted to the shareholder a 1% royalty interest in the Fatigue Fuse and a 0.5% royalty interest in EFS (see Note 7).  The balance due on this loan as of June 30, 2006 was $54,327.  Interest charged to operations for the three months ended June 30, 2006 and 2005 amounted to $406 and $406, respectively.  Interest charged to operations for the six months ended June 30, 2006 and 2005 amounted to $811 and $811, respectively.

In October 1996, the Company borrowed $25,000 from an unrelated third party.  The loan bears interest at an annual rate of 11% and matured on October 15, 2000.  The Company issued warrants to the lender for the purchase of 25 shares of the Company’s common stock at a price of $1.00 per share.  The loan balance as of June 30, 2006 was $25,000.  Interest charged to operations for the three-months ended June 30, 2006 and 2005 amounted to $685 and $685, respectively.  Interest charged to operations for the six-months ended June 30, 2006 and 2005 amounted to $1,375 and $0, respectively.  The Company did not pay any principal amounts due on this note when it matured on October 15, 2000 and the note is in default.  In 2004, the Company issued the shareholder 25,000 shares of its Class A common stock as additional compensation for the failure to pay off its indebtedness.  These shares are subject to a three-year lock up agreement and were valued at $59,000 and charged to interest expense in 2004.

On April 28, 2003, the Company borrowed $10,000 from an unrelated third party.  The loan is unsecured, non-interest bearing and due on demand.

Under the Debentures, each holder has the option to convert the principal amount of all monies loaned under the Debentures, together with accrued interest, into common stock of the Company at the lesser of (i) 50% of the average ten closing prices for the Company’s common stock for the ten days immediately preceding the conversion date or (ii) $0.10 (the lesser of the two being referred to as the “Conversion Price.”)  In addition, the Debentures provide that in the event the conversion price is less than $0.10 per share when the holder elects to convert, the Company would have the right, at any time during the 75 days following the date of the holder’s notice of conversion, to prepay all or a portion of the Debentures that have been requested to be converted and the Company would therefore not be required to issue the conversion shares.

Since the Debentures allow the holders to convert the outstanding principal amount into shares of the Company’s common stock at a discount to fair value, the Company recorded the fair value of the conversion feature of $1,125,000 in 2004.  The amount was recorded as a debt discount and is being amortized as interest expense over the life of the Debentures.  Total interest expense related to the amortization of the discount during the three months and six months ended June 30, 2006 was $99,855 and $199,710, respectively.  Total interest expense related to the amortization of the discount during the three months and six months ended June 30, 2005 was $99,855 and $199,710, respectively.  There was no change in the fair value of the conversion feature (included in derivative liabilities) during the three months ended June 30, 2006.

The Company’s president entered into a voting agreement and irrevocable proxy, which provides that as of September 23, 2006, if an event of default (as defined in the Debentures) continues for a period of not less than 30 days, all Class B common stock which Mr. Bernstein owns of record, or becomes the owner of record in the future will be voted in accordance with the direction of a third party named in the Debentures (an affiliate of Palisades) or his designated successor.  This loss of Mr. Bernstein’s voting rights would affect a change in the voting control of the Company.

The Debentures bear interest at an annual rate of 10%, are secured by substantially all assets of the Company and mature on December 31, 2006, when all principal and accrued interest becomes payable.  The balance of the Debenture, including accrued interest, at June 30, 2006 was $1,218,550 (net of unamortized discount of $199,710).  Interest expense on the Debentures for the three months and six months ended June 30, 2006, excluding amortization of the discount, was $34,499 and $67,798, respectively.

The Notes bear interest at 5.25% per annum, mature three years from the date of issuance and are convertible into the number of shares of the Company’s common stock equal to the dollar amount of the Notes being converted multiplied by 110, less the product of the conversion formula multiplied by 100 times the dollar amount of the Notes being converted, which is divided by the conversion formula.  The conversion formula is the lesser of (i) $0.70, (ii) eighty percent (the “Discount Multiplier”) of the average of the three lowest volume weighted average prices during the twenty trading days prior to the conversion or (iii) eighty percent of the volume weighted average price on the trading day prior to the conversion.  Accordingly, there is no limit on the number of shares into which the Notes may be converted.  The Company has agreed to register the shares that may be issued upon conversion of the Notes and exercise of the related warrants.

Beginning in the first full calendar month after the registration statement is declared effective, GGI has agreed to convert at least 5%, but no more than 10% of the face value of the Notes into shares of the Company’s common stock.  If GGI converts more than 5% of the Notes in any calendar month, the excess over 5% shall be credited against the subsequent month’s minimum conversion amount.  If GGI fails to convert at least 5% of the face amount of the Notes in any given calendar month, GGI will not be entitled to collect interest on the Notes for that month.  If the volume weighted average price of the Company’s common stock is below $0.20, the Company shall have the right to prepay that portion of the Notes that GGI is required to convert, plus any accrued but unpaid interest at 130% of such amount.  If at any time during the calendar month, the volume weighted average price is below $0.10, GGI shall not be obligated to convert any portion of the Notes during that month.

Beginning in the first full month after the registration statement is declared effective, GGI has agreed to exercise at least 5%, but no more than 10%, of the warrants per calendar month at an exercise price of $1.09 per share.  If GGI exercises more than 5% of warrants in any calendar month, the excess over 5% shall be credited against the subsequent month’s minimum exercise amount.  If GGI fails to exercise at least 5% of the warrants in any given calendar month, GGI will not be entitled to collect interest on the Notes for that month.  The warrants are exercisable through the maturity date of December 16, 2008.

The full principal amount of the Notes is due upon a default under the terms of the agreement.  The Company filed a registration statement within 60 days of closing, which included the common stock underlying the Notes and the warrants.  If the registration statement is not declared effective within 120 days from the date of filing, the Company will be required to pay a penalty to GGI (see above).  In the event the Company breaches any representation or warranty in the SPA, the Company is required to pay in cash, 130% of the then outstanding principal balance of the Notes, plus accrued and unpaid interest.

For a period of one year after the effective date of the SPA, GGI has agreed to restrict their ability to convert their Notes or exercise their warrants and receive shares of the Company’s common stock such that the number of shares of common stock held by them in the aggregate and their affiliates after such conversion or exercise does not exceed 9.99% of the then issued and outstanding shares of common stock.

The Notes include certain features that are considered embedded derivative financial instruments, such as the conversion feature, events of default and a variable liquidated damages clause.  These features are described below, as follows:

• The Notes’ conversion feature is identified as an embedded derivative and has been bifurcated and recorded on the Company’s balance sheet at its fair value;
  
  
• The SPA includes a penalty provision based on any failure to meet registration requirements for shares issuable under the conversion of the Notes or exercise of the warrants, which represents an embedded derivative, but such derivative has a de minimus value and has not been recorded in the accompanying consolidated financial statements; and
  
  
• The SPA contains certain events of default including not having adequate shares registered to effectuate allowable conversions; in that event, the Company is required to pay a conversion default payment at 130% of the then outstanding principal balance on the Notes, which is identified as an embedded derivative, but such derivative has a de minimus value and has not been recorded in the accompanying consolidated financial statements.

In conjunction with the Notes, the Company issued warrants to purchase 4,000,000 shares of common stock.  The accounting treatment of the derivatives and warrants requires that the Company record the warrants at their fair values as of the inception date of the agreement, which totaled $326,600. 

The initial fair value assigned to the embedded derivatives and warrants was $5,957,188.  The Company recorded the first $40,000 of fair value of the derivatives and warrants to debt discount (equal to the total proceeds received as of December 31, 2005), which will be amortized to interest expense over the term of the Notes.  Amortization expense charged to operations during the three months and six months ended June 30, 2006 was $3,333 and $6,666. 

The market price of the Company’s common stock significantly impacts the extent to which the Company may be required or may be permitted to convert the unrestricted and restricted portions of the Notes into shares of the Company’s common stock.  The lower the market price of the Company’s common stock at the respective times of conversion, the more shares the Company will need to issue to convert the principal and interest payments then due on the Notes.  If the market price of the Company’s common stock falls below certain thresholds, the Company will be unable to convert any such repayments of principal and interest into equity, and the Company will be forced to make such repayments in cash.  The Company’s operations could be materially adversely impacted if the Company is forced to make repeated cash payments on the Notes.

In May 2006, the Company entered into an addendum to the GGI Notes (see Note 6).  Per the terms of the agreement, the debenture amount has been increased from $40,000 to $1,000,000, and upon notification that the registration statement for the Conversion Shares (as defined in the agreement) has been filed with the SEC, GGI shall advance the Company an additional $20,000.  Additionally, upon the effective registration of the underlying shares, the Company shall issue 20,000,000 registered shares to be held in escrow and GGI shall transfer the Company the remaining debenture balance. The agreement modified the terms of the conversion as follows:

• the number of shares into which the Notes maybe converted is equal to the dollar amount of the Notes being converted divided by the conversion formula;
  
  
• eliminates the provision that if the volume weighted average price is less than $0.10 that GGI shall not be obligated to convert any portion of the Notes during that month;
  
  
• if GGI elects to convert a portion of the Notes and, on the day that the election is made, the volume weighted average price is below the lesser of : (i) $0.05, or (ii) the lowest price at which any of the 20,000,000 additional shares are issued or sold, the Company shall have the option to do one of the following: (a) redeem that portion of the Notes that GGI elected to convert, plus any accrued and unpaid interest, at 108% of such amount, or (b) increase the discount multiplier to 99% on that portion of Notes that GGI elected to convert, or (c) one time during any six-month period, not permit any Notes conversion by GGI for a period of 60 days; and

If GGI elects to convert a portion of the Notes and, on that day the election is made, the volume weighted average price is $0.32 or higher, the Discount Multiplier shall be 72%. 

The original 4,000,000 warrants issued have been cancelled.  In May 2006 and in connection with the modification of the GGI Notes, the Company issued to GGI 50,000,000 warrants to purchase common stock at a price of $0.01 per share, provided, however, in no event will the exercise price be lower or higher than the lowest price at which the Company sells any common stock (through direct issuance, conversion of debentures, etc, but not including stock issued for services) during the 30 days prior to the exercise date.  GGI has agreed to exercise the warrant shares at a rate of at least 1,250,000 shares per week once the registration statement has been declared effective.  Also, beginning in the first full calendar month after the registration of the underlying shares is declared effective, GGI must convert at least 10%, but no more than 40%, of the face value of the Notes per calendar month into common shares of the Company, provided that the common shares are available, registered and freely tradeable.    The Company may reduce the monthly maximum figure from 40% to 6% for any three calendar months (but not two consecutive calendar months) during the term of Notes by giving written notice at least 10 business days prior to the first applicable month.  GGI and the Company shall enter into three additional $1,000,000 convertible debentures, each with the same terms as above.  The agreement also allows the Company to register up to an additional 20,000,000 shares for sale or issuance to parties other than GGI in the registration statement.

As a result of the modification of the debt, the Company recognized a gain in the quarter ended June 30, 2006 on the debt extinguishment for the difference between the fair value of the Notes and warrant and derivative liabilities immediately before the modification and after the modification as part of the change in fair value of derivative and warrant liabilities.

The balance of the Debenture, including accrued interest, at June 30, 2006 was $59,361 (net of unamortized discount of $31,111).  Interest expense on the Debentures for the three and six months ended June 30, 2006, excluding amortization of the discount, was $725 and $1,265, respectively.

Shareholder Notes

During the three-months ended June 30, 2006, the Company borrowed $450,697 from three shareholders.  These loans bear interest at an annual rate of 6% and have a one year maturity.  The Company has the option to repay principal and accrued interest in cash or by issuing a total of 6,450,000 shares of its common stock.  Interest accrued during the three-months ended June 30, 2006 and charged to operations totaled $3,968.  In connection with these loans, the Company paid fees totaling $35,049 which have been classified as a prepaid expense and are being amortized to operations over the term of the debt.  For the three-months ended June 30, 2006, amortization expense amounted to $5,805 which was charged to interest expense.

Since the shareholder notes allow the holders to convert the outstanding principal amount into shares of the Company’s common stock at a discount to fair value, the Company recorded a BCF of $450,697 in 2006.  The amount was recorded as a debt discount and is being amortized as interest expense over the life of the Debentures.  Total interest expense related to the amortization of the discount during the three months ended June 30, 2006 was $112,674.  The balance of the shareholder notes, including accrued interest, at June 30, 2006, was $454,421.

On August 30, 1986, the Company entered into a funding agreement with the Advanced Technology Center (“ATC”), whereby ATC paid $45,000 to the Company for the purchase of a royalty of 3% of future gross sales and 6% of sublicense revenue.  The royalty is limited to the $45,000 plus an 11% annual rate of return.  At June 30, 2006, the future royalty commitment is approximately $358,000.  The payment of future royalties is secured by equipment used by the Company in the development of technology as specified in the funding agreement.

On May 4, 1987, the Company entered into another funding agreement with ATC, whereby ATC provided $63,775 to the Company for the purchase of a royalty of 3% of future gross sales and 6% of sublicense revenues.  The agreement was amended August 28, 1987, and as amended, the royalty cannot exceed the lesser of (1) the amount of the advance plus a 26% annual rate of return or, (2) total royalties earned for a term of 17 years.  At June 30, 2006, the total future royalty commitments, including the accumulated 26% annual rate of return, were approximately $5,416,000.  If the Company defaults on the agreement, then the obligation relating to this agreement becomes secured by the Company's patents, products, and accounts receivable that are related to the technology developed with the funding.

In 1994, the Company issued to Variety Investments, Ltd. of Vancouver, Canada (“Variety”) a 22.5% royalty interest on the Fatigue Fuse in consideration for the cash advances made to the Company by Variety.  In December 1996, in exchange for the Company issuing 250 shares of its common stock to Variety, Variety reduced its royalty interest to 20%.  In 1998, in exchange for the Company issuing 733 shares of its common stock to Variety, Variety reduced its royalty interest to 5%.

As discussed in Note 8, the Company granted a 1% royalty interest in the Company's Fatigue Fuse and a 0.5% royalty interest in EFS to a shareholder as partial consideration on a $25,000 loan made by the shareholder to the Company.

                                                                                              Fatigue Fuse                   EFS

Tensiodyne 1985-1 R&D Partnership                              10.00%   *                        -
Advanced Technology Center:
       Future gross sales                                                       6.00%   *                        -
       Sublicensing fees                                                      12.00% **                         -
Variety Investments, Ltd.                                                  5.00%                              -
University of Pennsylvania (see Note 7)
       Net sales of licensed products                                      -                               7.00%
       Net sales of services                                                    -                               2.50%
Shareholder                                                                      1.00%                        0.50%

*    Royalties limited to specific rates of return as discussed above.
**   The Company granted 12% royalties on sales from sublicense.  These royalties are also limited to specific rates of return as discussed above.

Through June 30, 2006, the Company owes no royalties under any agreements, as sales of the products have not yet begun.

Litigation

In July 2002, the Company settled its pending lawsuit related to a contract dispute with Mr. Stephen Beck.  In March 2006, Mr. Beck filed a lawsuit against the Company alleging breach of contract related to the lawsuit settlement and seeks approximately $135,000 in damages, plus the issuance of 3,896,620 shares of the Company’s common stock to which he believes he is entitled, plus interest.  The Company has only recently been served with the lawsuit and does not have an opinion as to its validity at this time.  During the three months ended March 31, 2006, the Company issued Mr. Beck 1,203,084 shares of its common stock related to ongoing negotiations with Mr. Beck.  The value of the shares issued to Mr. Beck was $173,244 and has been included in general and administrative expenses in the accompanying statement of operations.

The Company has also been named as a defendant in a lawsuit alleging breach of contract due to the Company’s failure to pay certain amounts due to a consultant for services.  The Company asserts that the contract was unenforceable due to a number of factors.   Legal counsel has advised the Company that it is premature to estimate the outcome or the range of damages that may occur if the case is not settled in the Company’s favor.

During the normal course of business, the Company has made certain indemnities and guarantees under which it may be required to make payments in relation to certain transactions.  These indemnities include certain agreements with the Company’s officers under which the Company may be required to indemnify such person for liabilities arising out of their employment relationship.  They also include indemnities made to the holders of the convertible debentures and the sellers of investments in securities.  The duration of these indemnities and guarantees varies, and in certain cases, is indefinite.  The majority of these indemnities and guarantees do not provide for any limitation of the maximum potential future payments the Company would be obligated to make.  Historically, the Company has not been obligated to make significant payments for these obligations and no liability has been recorded for these indemnities and guarantees in the accompanying consolidated balance sheet.

NOTE 8 – STOCKHOLDERS' DEFICIT

Class A Preferred Stock

The holders of the Class A convertible preferred stock have a liquidation preference of $720 per share.  Such amounts shall be paid on all outstanding Class A preferred shares before any payment shall be made or any assets distributed to the holders of the common stock or any other stock of any other series or class ranking junior to the shares as to dividends or assets.

These shares are convertible to shares of the Company's common stock at a conversion price of $0.72 (“initial conversion price”) per share of Class A preferred stock that will be adjusted depending upon the occurrence of certain events.  The holders of these preferred shares shall have the right to vote and cast that number of votes which the holder would have been entitled to cast had such holder converted the shares immediately prior to the record date for such vote.  The holders of these shares shall participate in all dividends declared and paid with respect to the common stock to the same extent had such holder converted the shares immediately prior to the record date for such dividend.

Class B Preferred Stock

The Company has designated 15 shares of Class B preferred stock, of which no shares have been issued.  The holders of Class B preferred shares are entitled to a liquidation preference of $10,000 per share.  Such amounts shall be paid on all outstanding Class B preferred shares before any payment shall be made or any assets distributed to the holders of common stock or of any other stock of any series or class junior to the shares as to dividends or assets, but junior to Class A preferred shareholders.  Holders of Class B preferred shares are not entitled to any liquidation distributions in excess of $10,000 per share.

The shares are redeemable by the holder or the Company at $10,000 per share.  The holders of these shares shall have the right to vote at one vote per Class B preferred share and shall participate in all common stock dividends declared and paid according to a formula as defined in the series designation.

Class C Preferred Stock

Each shareholder of Class C preferred stock is entitled to receive a cumulative dividend of 8% per annum for a period of two years.  Dividends do not accrue or are payable except out of earnings before interest, taxes, depreciation and amortization.  At June 30, 2006, no dividends are payable to Class C preferred shareholders.  Holders of the Class C preferred stock are junior to holders of the Company’s Class A and B preferred stock, but hold a higher position than common shareholders in terms of liquidation rights.  Holders of Class C preferred stock have no voting rights.  Holders of Class C preferred stock have the right to convert their shares to common stock on a one-to-one basis.

The Company requires an approval of at least two-thirds of the holders of Class C preferred shareholders to alter or change their rights or privileges by way of a reverse stock split, reclassification, merger, consolidation or otherwise, so as to adversely affect the manner by which the shares of Class C preferred stock are converted into common shares.

Class D Preferred Stock

Holders of Class D preferred stock have a $0.001 liquidation preference, no voting rights and are junior to holders of all classes of preferred stock but senior to common shareholders in terms of liquidation rights.  Class D preferred stockholders are entitled to dividends as declared by the Company’s Board of Directors, which have not been declared as of December 31, 2005.  Each share of Class D preferred stock is convertible at the holder’s option into one share of the Company’s common stock.

During 2005, 500,000 shares of Class D preferred stock were converted into 500,000 shares of the Company’s common stock. 

During the six months ended June 30, 2006, the Company converted the remaining 1,420,000 Class D preferred shares outstanding into 1,420,000 shares of the Company’s common stock.

Except for the Ischian sales (see below), during the six months ended June 30, 2006, the Company issued a total of 8,806,138 shares of common stock for total proceeds of $1,976,702 (net of offering costs of $3,600), of which $1,333,907 has not been collected but is included in notes receivable – common stock in the accompanying balance sheet.  The notes receivable balance is comprised of 4 separate notes.  Three notes receivable, totaling $333,907 in principal as of June 30, 2006, accrue interest at 6% and are due through May 2007.  During the quarter ended June 30, 2006 the Company recorded interest income of $2,439 related to these three notes.  The fourth note receivable, totaling $1,000,000, accrues interest at 6% and is due in August 2006.  During the quarter ended June 30, 2006 the Company recorded interest income of $8,219. 

During the six months ended June 30, 2006, the Company purchased 62,000 shares of its own common stock in the public market for a cost of $8,623.  During the six months ended June 30, 2006, the Company cancelled all 138,800 shares of its treasury stock.

In July 2005, the Company entered into a Regulation S stock purchase agreement (the “Ischian Agreement”) with Ischian Holdings, Ltd. (“Ischian”), a British Virgin Islands company.  Pursuant to the Ischian Agreement, Ischian was able to purchase up to 8.5 million shares of the Company’s common stock through November 2005 at a stated discount to the bid price of the Company’s common stock.  The shares purchased under the terms of the Ischian Agreement have a one-year restriction on resale within the United States.  A commission of 15 percent of the net proceeds from the sale of the Company’s common stock to Ischian, collectively, will be paid to two consultants.  During the six months ended June 30, 2006, pursuant to an isolated verbal extension of the agreement, the Company issued to Ischian a total of 5,351,240 shares of common stock.  Of these shares, 3,506,148 shares were issued for no additional consideration to reduce the average per share price paid by this investor pursuant to the agreement.  The remaining 1,845,092 shares were issued for cash consideration of $29,878.

In June 2006 Birchington purchased 1,755,000 shares for total proceeds of $17,550 in accordance with the downside protection provision of the April Birchington Agreement.  The Company reclassified $403,650 from investments derivative liability at the time of the share purchase.

From time to time, the Company issues its common shares and holds the shares in escrow on behalf of another party until consummation of certain transactions.  The following is a reconciliation of shares issued and outstanding as of June 30, 2006:

Common Shares Issued for Non Cash Consideration

The value assigned to shares issued for services were charged to operations in the period issued.

2006

On January 10, 2006, the Company issued 1,476,000 shares of its common stock to three consultants for services valued at $236,200.  On January 16, 2006, the Company issued 250,000 shares of its common stock to a consultant for services valued at $40,000.  On January 25, 2006, the Company issued 4,000,000 shares of its common stock to a consultant for services valued at $512,000.  On January 25, 2006, the Company issued 1,420,000 shares of its common stock in exchange for the cancellation of 1,420,000 shares of Class D preferred stock.  On February 1, 2006, the Company issued 1,000,000 shares of its common stock to a consultant for services valued at $120,000.  On February 8, 2006, the Company issued 500,000 shares to one of its advisors in connection to the development of its products valued at $36,000.  On February 8, 2006, the Company issued 600,000 shares of its common stock to a consultant for services valued at $72,000.  On February 13, 2006, the Company issued 1,203,084 shares of its common stock to Mr. Stephen Beck in connection with his lawsuit valued at $173,244 (see Note 7).  The shares were valued at par.  On February 22, 2006, the Company issued 50,000 shares of its common stock for clerical services valued at $5,600.  On February 23, 2006, the Company issued 700,000 shares of its common stock to its attorney for services valued at $72,800.  On March 1, 2006, the Company issued 50,000 shares of its common stock to a consultant for services valued at $5,600.  On March 14, 2006, the Company issued 3,900,000 shares of its common stock in connection with its private offerings.  The shares were valued $343,200 and charged to consultant expense.  On March 23, 2006, the Company issued 2,000,000 shares of its common stock to a consultant for services rendered valued at $336,000.  On March 29, 2006, 160,000 shares that were originally issued were returned to the Company, as they were issued in error.

Certain common shares issued above for services rendered were subject to a two-year lockup agreement and were valued at 80% of the market price of the Company’s common stock on the respective date of issuance.

2005

On January 14, 2005, the Company issued 500,000 shares through the conversion of 500,000 shares of its Series D preferred stock.  On February 7, 2005, the Company issued 400,000 shares for consulting services.  These shares are subject to a 30-month lock-up agreement and were valued at $555,000. On March 11, 2005, the Company issued 75,750 shares for consulting services.  The shares are subject to a two-year lock-up agreement and were valued at $90,000.  On March 24, 2005, the Company issued 500,000 shares for consulting services.  The shares are subject to a two-year lockup and were valued at $580,000. 

The Company has three stock option plans:  The 1998 Stock Plan (“the 1998 Plan”), the 2002 Stock Issuance/Stock Plan (“the 2002 Plan”) and the 2003 Stock Option, SAR and Stock Bonus Consultant Plan (“the 2003 Plan”).

In September 1998, the Company adopted the 1998 Plan and reserved 800,000 shares of its common stock for grant under the plan.  Eligible participants include employees, advisors, consultants and officers who provide services to the Company.  The option price is 100% of the fair market value of a share of common stock at either the date of grant or such other day as the as the Board may determine.  The plan expires upon the earlier of all reserved shares being granted or September 10, 2008.

In September 2003, the Company adopted the 2003 Plan and reserved and 10,000,000 shares of its common stock for grant.  Eligible plan participants include independent consultants.  The option price shall be no less than 85% of the fair market value of a share of common stock at date of grant.  The plan expires upon the earlier of all reserved shares being granted or September 23, 2006.

The Company also has agreements with two consultants whereby the Company will grant options to purchase shares of its common stock upon the Company increasing its annual revenue by $5 million in any fiscal year over its revenues in 2002.  The collective number of shares to be issued will give the two consultants a fifteen percent interest in the outstanding shares of the Company’s common stock.  No grants have been made pursuant to these agreements as the Company has not achieved the required revenues.  There was no activity in any of the Company’s stock option plans in 2006 or 2005 and no options were outstanding as of June 30, 2006.

Stock Warrants

At June 30, 2006, the Company’s only outstanding warrants are the 50,000,000 warrants associated with GGI (see Note 6).

NOTE 11 – SUBSEQUENT EVENTS

Subsequent to June 30, 2006 the Company issued: 1,113,250 shares of common stock for services, valued at approximately $85,000; 38,964,082 shares of common stock in escrow in connection with a pending transaction that is expected to close in the third quarter of 2006; and 774,626 shares of common stock under the Ischian agreement for total net cash proceeds of approximately $19,000.

On July 17, 2006, Palisades converted $100,000 of its convertible note into 2,500,000 shares of Class A common stock in accordance with the terms of the Debentures.

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